7/06/2009 @ 5:03PM

Forbes Classic: Red Ink Alert

This article originally appeared in the April 1, 1969, issue of Forbes magazine.

According to some very pessimistic estimates, Lockheed Aircraft Corp. could lose $600 million on its contract to build 58 giant cargo and transport planes for the Air Force.

The aerospace industry predicts that North American Rockwell will lose close to $100 million on its subcontract from General Dynamics to produce bombsights and navigation radar for the F-111 fighter bomber.

United Aircraft, which has a sub-subcontract on the equipment, already has written off $35 million.

Boeing may lose $10 million on its development contract for the short-range attack missile.

All are hoping, however, that the U.S. government will show them some mercy. The question is: How much mercy?

The defense companies have at least a chance of getting the government to make up some or all of their losses. Why? Partly because inflation is making original estimates worthless. Another reason: With profits on government contracts strictly limited, why should potential losses be unlimited?

In years past, these arguments almost certainly would have gotten a sympathetic hearing both at the Pentagon and on Capitol Hill. Now, an increasingly budget-minded Defense Department and Congress are showing resistance.

Until Robert S. McNamara became Secretary of Defense, contracts for new weapons systems usually were on a cost-plus-6% basis–which meant that profits were virtually guaranteed. But McNamara felt these contracts didn’t give any incentives for the contractors to save the government money.

To remedy this, McNamara introduced fixed-price incentive contracting, under which the contractors could make higher profits if they kept costs under control. Along with this carrot went a stick: The profit margin went down as costs went up; if they went above a set ceiling, the contractor lost money.

Later, McNamara introduced another change in contracting–total-package procurement. This meant that a total weapons system–its development, production, training and spare parts–were all bought in a single contract. Previously, the aerospace companies had vied only for the development end, and the winner received the production end as a matter of course. The old system encouraged contractors to bid low on development contracts because, without competition, they could more than recoup on the production end.

The McNamara methods certainly went far toward putting defense contracting on a more businesslike basis. But they have not, obviously, made life easier for the companies involved–especially with inflation getting out of hand.

At any rate, the Pentagon so far has been taking a dim view of the companies’ pleas for the government to bail them out. “A lot of companies don’t realize that we meant business, that they couldn’t bid low and get well later,” says Robert H. Charles, Assistant Secretary of the Air Force, who is credited with fathering the total-package concept. Adds Deputy Assistant Secretary of Defense John Malloy: “We insist on contract commitments.”

The aerospace industry has many sympathizers, among them new Defense Secretary Melvin Laird and, in Congress, the chairmen of the armed forces and appropriations committees–Richard B. Russell of Georgia and John Stennis of Mississippi in the Senate, and Mendel Rivers of South Carolina in the House. On the other hand, in both the Senate and the House, the demand has been growing to put a curb on defense spending. Even Senator Stuart Symington of Missouri, the former secretary of the Air Force, has joined the clamor.

The contractors will probably get some relief. It’s likely the Pentagon will modify the contract system inaugurated by McNamara, for Malloy says: “Tuning the system may be in order. There can be a hard contract for most of the program and another type of arrangement for the predicted high-cost areas.” But, significantly, he talks of “tuning” the system, not changing it. Even with McNamara gone, the defense industry knows that it is in for a hard time if it can’t meet cost estimates.